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Lebanon: Staff Concluding Statement of the 2018 Article IV Mission

February 12, 2018

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

The approaching elections are an opportunity to engage the public in a
dialogue on how to support macroeconomic stability and implement
structural reforms to raise inclusive growth and create jobs. Further,
the upcoming Paris Conference is an opportunity to mobilize
international support for these efforts. The authorities have some
significant achievements in recent months, notably passing the first
budget in over 12 years in October 2017. However, the overall economic
situation remains fragile with prolonged low growth, public debt
rapidly rising beyond 150 percent of GDP, and a persistent current
account deficit of more than 20 percent of GDP. To preserve confidence
in the system there is an urgent need to establish a policy framework
that supports macroeconomic stability. This statement highlights key
findings and recommendations of the recent Article IV Consultation
mission to Lebanon (February 1-12, 2018), based on our discussions with
a broad range of stakeholders. A more complete analysis of policy
issues will be included in the forthcoming staff report. We thank the
Lebanese authorities and other counterparts for their hospitality, and
for a rich and fruitful set of discussions.

Key messages

The reform agenda needs to focus on three areas:

First, fiscal policy needs to be immediately anchored in a consolidation
plan that stabilizes debt as a share of GDP and then places it on a clear
downward path. Any scaling up of public investment will need to be grounded
in such an adjustment plan and must be preceded by strengthening the public
investment management framework.

Second, financial stability risks should be contained, including by
incentivizing banks to gradually strengthen their buffers and by taking
further actions designed to strengthen credit quality.

Third, to promote sustainable growth and improve equity and
competitiveness, the electricity sector needs to be reformed and the
anti-corruption regulatory framework should be enhanced and made effective.

Context

1.
Lebanon has emerged from the political crisis of November 2017, but
vulnerabilities are higher.
Interest rates on new local-currency bank deposits are 2–3 percentage
points higher than before the crisis, and the economic system’s dependence
on depositor confidence has deepened.

2.
The authorities are planning to initiate a large capital investment
program
(CIP).
Lebanon continues to host around 1 million registered Syrian refugees
(equivalent to about a quarter of the population). The aims of the CIP are
to raise Lebanon’s growth and also alleviate the burden on both host
communities and refugees. The authorities have indicated that they plan to
raise up to $16 billion (32 percent of current GDP) over the next decade by
tapping into the World Bank’s Concessional Financing Facility,
public-private partnerships, and other facilities that provide grants or
long-term concessional lending. A conference in Paris to support investment
in Lebanon is tentatively scheduled for April 2018.

3.
The underlying economic situation has not changed and remains
challenging, with high public debt, current account deficit, and
funding needs.
Public debt is estimated above 150 percent of GDP at end-2017, and is
expected to rise rapidly with a budget deficit above 10 percent over the
forecast horizon. The current account deficit is expected to remain above
20 percent. The funding environment has been affected by the political
crisis of November 2017. Without a significant reduction in the economy’s
funding needs or an increase in deposit inflows (and given the global
interest rate outlook), the Banque du Liban (BdL) will need to increase
interest rates or use its sizable gross reserves to meet the funding needs
of the economy. The budget of 2018 and preparation for the upcoming Paris
conference could provide key platforms to initiate the much-needed economic
reforms.

The Economic Backdrop

4. Growth remains low.
We estimate growth to be at about 1–1.5 percent for 2017 and 2018. The
traditional drivers of growth in Lebanon—tourism, real estate, and
construction—remain slow and a strong rebound is unlikely soon. According
to the BdL, real estate prices declined by over 10 percent over 2017, while
the purchasing managers’ index indicates that private sector confidence
continues to be weighed down by political uncertainty. Inflation in 2017
reached 5 percent, likely due to a rise in the costs of imports, notably
oil, and a weaker U.S. dollar.

5.
The fiscal situation remains very difficult and poses significant
risks.
In July 2017, the Lebanese parliament approved an across-the-board increase
in the salary scale of public sector employees and pensions of retired
civil servants. A range of tax and fee increases was approved during the
second half of the year. While the net fiscal impact is expected to be
broadly neutral in 2018, higher personnel and interest costs will be main
contributors to further deteriorating fiscal position over the projection
horizon. The overall budget deficit in 2017 is expected at 7.3 percent of
GDP, with a primary balance of 2.4 percent—in part due to one-off revenues
from taxing higher bank profits due to BdL financial operations. In
addition, subsidies to Electricité du Liban (EdL) are increasing, in part
due to rising oil prices.

6. External imbalances are large and persistent.
The nominal effective exchange rate appreciated sharply in recent years,
while the real effective exchange rate (REER) also strengthened in 2017 by
2.8 percent. The current account deficit is projected to have remained
above 20 percent in 2017. Goods exports as a share of GDP continue to
decline, while imports remain strong, in part due to cheap credit made
available by several BdL subsidy schemes and higher oil prices. The
persistently large current account deficit and other imbalances are
evidence of a significant REER overvaluation.

7. Sustaining deposit inflows is challenging.
In the past, foreign-deposit inflows have been a key source of financing
for the large current account- and budget deficits. However, deposit growth
has eased in recent years. Private sector deposit growth was 3.8 percent in
2017—below the average growth in previous years.

8.
In response, the BdL continues to expand its unconventional financial
operations.
The BdL has introduced several new financial operations since summer 2016
that offer large incentives to domestic commercial banks to invest in BdL’s
dollar-denominated term deposits. Consequently, the increase in bank
exposure to the BdL has accelerated since summer 2016. While these
operations have boosted the gross reserves of the BdL and the capital of
banks, they have come at a cost to the BdL’s balance sheet and net FX
position, and have been regressive. In addition, the BdL introduced a new
operation in December 2017 to incentivize banks to secure longer maturity
local-currency deposits, by increasing the interest rate on existing BdL
long‑term instruments held by banks by 2–3 percentage points.

9.
The sovereign credit ratings reflect the challenges faced by Lebanon.
Moody’s downgraded Lebanon from B2 to B3 in August 2017, while Fitch and
S&P have maintained their ratings at B-/B3 equivalent. During the
political crisis of November 2017, the spreads of Lebanese Eurobonds
vis-à-vis other emerging market instruments spiked by 200-300 bps, but
returned to pre-crisis levels by January 2018.

10. Lebanon’s outlook remains uncertain.
Under our baseline scenario, growth will gradually rise close to 3 percent
as external demand picks up due to a global recovery. Inflation is expected
to remain around its trend of 2.5 percent. Overall fiscal balances are
expected to reach well above 10 percent of GDP and public debt close to 180
percent of GDP by 2023. The current account deficit will remain large.
Under the baseline assumption of no reforms or increase in interest rates,
Lebanon’s reserve adequacy position is projected to deteriorate over the
medium term. But the projection is subject to both upside and downside
risks. On the upside, Lebanon’s outlook is linked closely to developments
in Syria. In the event of an early resolution, Lebanon would be well placed
to benefit from the reconstruction effort, as well as from the
reestablishment of trade and an improvement in regional investor
confidence. This would have significant and positive implications for local
incomes and growth, though not enough to restore debt sustainability
without adjustment. On the downside, tensions in the region could lead to
escalation of conflicts or trigger security incidents, higher oil prices
could increase Lebanon’s funding needs, or deposit inflows could decelerate
putting pressure on foreign exchange reserves.

Policy Priorities

11.
Lebanon needs urgent action to preserve confidence in the system and
take advantage of international support.
Over the past several years, Lebanon has maintained a policy mix of loose
fiscal policy, and high real rates on bank deposits combined with cheap
private sector credit through various quasi-fiscal subsidy schemes.
However, given rising vulnerabilities, the need to establish a policy
framework that places the economy and public debt on a more sustainable
path has only increased. The increased engagement by some donor countries
also offers an opportunity to secure their support for a reform and
investment plan. The reform agenda needs to focus on three areas.

Critical Need for a Fiscal Consolidation Plan

12.
Significant fiscal adjustment is inescapable if the current economic
policy framework of a fixed exchange rate sustained by high deposit
inflows is to be maintained.
Lebanon’s debt is unsustainable under the baseline scenario. In the context
of Lebanon’s low growth and rising global interest rates, debt dynamics
will deteriorate further and public debt will increase rapidly to just
below 180 percent of GDP by 2023 under the baseline and continue to rise
thereafter. Similarly, without adjustment, government financing needs will
continue to rise; the underlying codependence between banks and the
sovereign will intensify; and Lebanon’s growing reliance on deposit inflows
will expose the economy even more to sudden swings in depositors’
confidence.

13.
The size of adjustment needed to halt the rise in public debt is still
within reach, but it would require significant efforts, and would not
by itself guarantee sustainability.
A combination of increases in revenues and cuts in current spending
amounting to about 5 percent of GDP is needed over the medium term to
stabilize public debt as a share of GDP and place it on a gradually
declining path. Such a large adjustment is undoubtedly costly, but in the
case of Lebanon it needs to be viewed against mounting funding needs and
high budget deficits reaching above 10 percent of GDP. A comprehensive
fiscal adjustment and economic reform program would greatly improve
economic conditions, including public debt ratios. However, it would not be
without risks. The fiscal adjustment required has only been achieved in
very few countries. There would also be continued large current account
deficits even after fiscal adjustment, in the absence of exchange rate
adjustment and/or significant structural reforms, which would leave
sustainability in question.

14.
The CIP could have positive effects on growth, but would need to be
accompanied by strong fiscal adjustment and structural reforms.
The CIP, if implemented with well selected projects, will likely boost
economic growth in the short term, but at the same time will increase
public debt, and possibly borrowing cost. Any scaling up of investment will
need to be grounded in a comprehensive macroeconomic adjustment plan
designed to stabilize public debt ratios and then put them on a gradually
declining path, and preceded by improved public investment management.

15.
A fiscal consolidation plan with front‑loaded fiscal adjustment,
embedded in a credible budget, is urgently needed.
The proposed adjustment package combines revenue and spending measures. The
measures include (i) increasing VAT rates, while limiting exemptions and
refunds and improving compliance; (ii) reinstating gasoline excise and fuel
taxes to levels that prevailed before 2012; and (iii) gradual elimination
of the electricity subsidy. The adjustment proposal would significantly
improve the trajectory of public debt. In addition, there is scope to
contain personnel spending and undertake a civil service reform. This would
reduce expenditure rigidity and create fiscal room to strengthen the social
safety net to increase protection of the vulnerable.

16.
The public investment management framework should be strengthened
before undertaking large investment projects.
Strengthening the institutional framework based on a formal assessment is
crucial before undertaking large investments. Risks and fiscal costs
arising from any PPPs needs to be contained. Furthermore, given capacity
constraints, the authorities should consider a gradual scaling up of
investment, to limit fiscal and implementation risks. Highly-concessional
financing should be sought and domestic financing of public investment
should be avoided.

Normalizing Monetary Framework and Preserving Financial Stability

17.
The current policies of the BdL have helped preserve stability but also
created market distortions.
The BdL maintains the fixed exchange rate, helps finance the government by
offering long-term instruments to banks, keeps interest rates steady at
moderate levels by underwriting both the T-Bill and Eurobond primary
markets, provides economic stimulus by a range of quasi-fiscal subsidy
schemes, addresses weak banks, and subsidizes deposit rates to lengthen
their maturity. While the range of these operations has allowed the BdL to
play a critical role in maintaining the current economic model and
effectively manage crisis episodes, these policies are also associated with
costs. They have resulted in the creation of new reserve money, weakened
BdL’s balance sheet, and created a different set of financial stability
risks by exposing banks to significant sovereign exposure and maturity
mismatches.

18.
The materialization of various shocks could expose vulnerabilities in
the banking system.
The recent increase in bank capital levels is welcome. While regulatory
capital requirements exceed the minimum levels set under the Third Basel
Accord, banks’ capital buffers are modest in light of their significant
exposure to local-currency sovereign debt and foreign-currency BdL
instruments—and sovereign risk weights are not in line with international
standards. The rising interest rate environment also poses risks to banks
profitability and capital positions. In addition, the slowdown in the
economy and in the real estate sector, and rising interest rates, are
likely to have affected credit quality and there are signs that
nonperforming loans will increase.Lastly, foreign assets
of commercial banks remain low, in part driven by banks transferring their
FX placements from abroad to the BdL—motivated by BdL financial operations.

19.
Going forward, the BdL should rely on conventional interest rate policy
instead of financial operations.
If deposit growth were to further soften, the BdL should maintain tight
liquidity and raise interest rates to secure foreign exchange
inflows—rather than relying on a repeat of financial operations. This will
help the BdL to improve its FX position, and create incentives for banks to
rebuild their liquidity buffers, while reducing the risk of a further rise
in dollarization. It would also help to rein in the sizable private sector
debt growth, contain inflationary pressures, and limit further
deterioration of BdL’s balance sheet. The recommended fiscal consolidation
plan would mitigate the negative impact of higher interest rates on debt
dynamics, since gross financing needs would decline. The BdL should also
gradually withdraw from the T-Bill and Eurobond primary market and reduce
reliance on quasi-fiscal schemes.

20.
Buffers in the banking system should continue to be strengthened and
steps should be taken to address rising credit risks.
The sovereign risk weights should be aligned with the Basel Accord, and
banks should engage in forward-looking capital planning in line with their
risk profiles, and linked to multi-factor stress testing. In addition, the
regulatory treatment of nonperforming/restructured loans should be aligned
with international good practice, monitoring of loan-loss migrations at the
bank level should be improved, and sustainable restructuring of
nonperforming loans should be encouraged. Lastly, it will be important to
enhance liquidity regulations to incentivize increase in deposit maturities
and to ensure that banks do not weaken their short-term foreign currency
liquidity buffers further.

21.
The authorities should strengthen the crisis management framework and
AML/CFT framework.
In the past, weak small- and medium-sized institutions have been promptly
handled, mainly through mergers, without jeopardizing financial stability.
In line with the 2016 FSAP advice, the authorities should consider
developing resolution options that enable the closures of failed banks,
reform of the National Institute for the Guarantee of Deposits (NIGD) to
become an operationally independent agency funded by premiums paid fully by
banks, increase deposit insurance coverage levels, and ensure that the
resolution regime awards preferential treatment to insured depositors and
the NIGD. In addition, the AML/CFT framework should continue to be
strengthened in line with the 2016 FSAP advice.

Promoting Structural Reforms

22.
Given eroding competitiveness and low growth, structural reforms are
essential
. Even after accounting for the impact of the Syrian conflict, the external
balance is weaker than suggested by fundamentals, pointing to an underlying
problem with productivity and competitiveness. Lowering the cost of doing
business, and improving services—in particular electricity provision—will
promote jobs for both Lebanese nationals and refugees, while also
strengthening social safety nets. Structural reforms are essential to
improving competitiveness and growth, and reducing external sector
vulnerability.

23.
Electricity reform and eradicating corruption are long-standing
priorities
. The electricity sector has not only been widely identified as Lebanon’s
most pressing bottleneck, but it also remains a significant drain on the
budget. A more reliable service by EdL would reduce the need for expensive
private generators, even after tariff increases, and contribute to more
efficiency in the economy at large. In addition, the government
acknowledges that corruption is widespread and is associated with large
social and economic costs. Addressing corruption and improving governance
should be an essential component of Lebanon’s reform agenda.

24.
Electricity reforms should focus on expanding capacity and eliminating
subsidies.
Stillrelatively low oil prices present an opportunity to
begin to raising tariffs up to cost-recovery levels while simultaneously
expanding capacity—though in a way that protects more vulnerable consumers.
The benefits of reform would be sizable, in terms of significant budget
savings including by eliminating the need for private generators, reduced
business costs, and more efficient consumption. The authorities could
combine the fiscal adjustment with expansion of social assistance programs
to mitigate the impact on low-income households.

25.
The anti-corruption regulatory framework should be made effective.
The regulatory framework to fight corruption needs to be significantly
enhanced and made operational. This should include passage of legislation
to protect whistleblowers; making the illicit wealth law more effective by
making the asset declaration system for senior public officials (and their
family members and associates) public, with a system of audits, and
combined with measures for banks to control and report suspicious
activities related to politically exposed persons; establishing and
adequately resourcing the planned anti-corruption body with sufficient
enforcement powers; and enhancing fiscal transparency including by
strengthening governance in the revenue and customs administrations,
improving revenue compliance, making the procurement system transparent,
and introducing an external audit agency.

26. Finally, there is a long-standing need to improve data quality.
This could improve access to international investment, and enhance
evidence-based policymaking. At a minimum, the quality, frequency, and
timeliness of national accounts and balance of payment statistics needs to
be improved; data on employment, unemployment and wages need to be
frequently collected and published; trade in goods and services data needs
to be enhanced; quality of indicators to monitor economic activity need to
be improved; and inter-agency dialogue and sharing of information should be
strengthened.